What the IRS Bitcoin Tax Guidelines Mean For You

The US Internal Revenue Service finally announced its guidance for virtual currencies yesterday, explicitly referring to bitcoin (see the announcement here and notice here). The increased clarity – provided three weeks before the end of the US tax year – will come as a relief to many who were scared to get involved in bitcoin, commercially. But what does it mean for different members of the bitcoin community?

US businesses wanting to get involved in bitcoin have been waiting for this for a while. As recently as January, US Taxpayer Advocate Nina Olson pressured the IRS in her annual report to Congress, telling it that it needed to publish guidance. The lack of rules was a serious problem, she said, and many businesses would be surprised to hear that capital gains could be imposed on bitcoins.

Well, now, that's official: in its guidance, the IRS has said that bitcoin should be treated as property, making it subject to capital gains tax. That has significant ramifications for different kinds of businesses and individuals dealing in bitcoin.

Miners

Miners that produce their own bitcoins are now subject to two different tax charges. They must include the fair market value of the virtual currency on the day that it is mined into their gross income.

Another stipulation in the IRS guidance is that capital gains are due on the sale of bitcoins viewed as a capital asset. The taxpayer must take this fair market value on the date of acquisition as the basis price for the coins. Capital gains will be due on the difference between that basis price and the eventual sale price.

This means that if and when they sell the bitcoins that they have mined, they will have to pay capital gains tax on any profit that they have made while owning them. Furthermore, if an individual mines bitcoin as a business, the net earnings from that business will be treated as self-employment income, and will be subject to self-employment tax.

Dave Carlson, a US entrepreneur who runs a mining operation that earned almost $8m a month in revenue when bitcoin was at its peak, says that this could spell trouble for miners.

"The implications of the new IRS tax guidance will be a major factor for those US miners who didn't anticipate it and are already on the edge of profit. A capital gains tax on all coins mined could drive mining revenue below cost of power for many, forcing them to shut down," he says. "Pool operators will have to issue 1099s to all their US contributors, which will drive pool fees higher.

The exception here is if bitcoins aren't viewed as capital assets, but are instead viewed as inventory. This would be the case if a miner (or any other business) made the selling of bitcoins their core business. In that case, any gains on the bitcoins would be taxed as an ordinary gain or loss.

"The test depends on the facts and circumstances and there's not a simple bright line rule," says Tyson Cross, a San Diego tax attorney who runs Bitcoin Tax Solutions, an advisory site about bitcoin taxation. "Asking yourself if you're a miner, how you fall into that test, will be kind of murky."

At least one miner has a strategy to get around the taxing of bitcoin when mined, though. Yana Kesler, a certified public accountant from Philadelphia, purchased a $7,200 mining rig last year, and had it hosted in Europe.

"When you mine yourself you are the producer. When you ask someone else to mine for you, that's your investment," Kesler says. She calculates the basis value of her coins as zero, but says that she does declare capital gains when she sells the coins.

Investors

The same basic concepts for capital gains realizations apply to investors who obtain their bitcoins through exchanges. They must measure the fair market value on that day as the basis for capital gains realization when they eventually sell the coins.

This is a good thing for investors though, argue tax experts. The alternative would be to impose foreign currency gains on most profits, which are taxable at a higher rate. Instead, investors who hold their bitcoins for more than a year and a day will be charged at the long-term capital gains rate, which currently rests at 15%.

This is what serious investors have been rooting for all along. "Winklevoss called it," says Jacob Farber, an attorney in the virtual currency group at legal firm Perkins Coie, referring to the SEC filing for the Winklevoss Bitcoin Trust. "They said that it should be treated as subject to capital gains. As investors that would be the right outcome."

There's another upside for investors, says Cross: certainty. "That's a huge issue for investors, especially institutional investors," he says, adding that he spoke to several institutional investors who were on the fence because of a lack of IRS guidance.

Exchanges

The exchanges themselves may have a tougher time of it, though. Farber's colleague Richard Peterson, chair of Perkins Coie's tax practice, says that now bitcoin is being classed as property, this will impose a reporting overhead. The key here is the 1099-B federal tax form, used to report the proceeds of a broker or barter exchange.

"If I sell my shares through Merrill Lynch, they send me a 1099 on which they have to list the property sold, the date it was sold, the price, and then if they have the information they would have to report my tax basis and my gain or loss," he says. "They would need to do that for every transaction I do for the entire year, and send me one statement."

He suggests that exchanges may now have to file such a form describing every transaction made by a client. For some high-volume clients, this could run into hundreds of trades each year. Are bitcoin exchanges, which haven't been legally bound to do this, ready for the administrative burden?

Jaron Lukasiewicz, CEO of New York-based exchange Coinsetter, couldn't comment on whether the firm was set up to do that today, or whether its systems would need to be altered to accommodate the change.

"Companies in the space will now have to determine how to help customers report taxable gains properly, which won't be easy," Lukasiewicz says. "However, I don't think this tax treatment is a huge surprise to most people who have bitcoin gains."

Consumers

Tracking capital gains represents a sticky problem when it comes to bitcoin owners paying for goods and services using the digital currency.

If you convert your bitcoins to fiat currency and then make everyday purchases using dollars, it will be relatively easy to report the short or long-term capital gains from that single transaction.

But if you use the bitcoins in your wallet to purchase goods directly, then theoretically, the IRS should be informed of the capital gains incurred on the bitcoin at the time of the purchase, pointed out various tax attorneys that CoinDesk quizzed yesterday.

If you bought $25 in bitcoins, and they went up by $75 in value, and then you went to Overstock and bought a sweater using bitcoins, then technically speaking, you should account for the $75 in capital gains when you spend those coins, says Peterson.

"That's the gain that the service is going to want to track when retailers accept bitcoin. That's where the true administrative nightmare comes in. There would have to be some town hall meeting with the [IRS] to resolve that."

This rule imposes an unrealistic burden on bitcoin users. At best, if they rule was enforced then they would have to rely on a merchant providing the current US dollar value for a bitcoin purchase for their records, attorneys said. They would then have to compare this dollar value with the basis price (that is, the fair market value of the bitcoins on the day that they acquired them).

The consumer would have to do this for every bitcoin-based purchase that they made throughout the year, and add it all up at the end. If the merchant accepting bitcoin for payment didn't provide a current US dollar value, then the person spending the bitcoin would have to do the math themselves, making it doubly hard to keep track.

None of this makes bitcoin attractive as an everyday unit of exchange, argue attorneys.

In practice, though, it seems unlikely that anyone would do this. Greg Broiles, an attorney specializing in estate planning, trust and probate, who spoke on bitcoin and taxation at Bitcoin 2013, argues that accountants have a concept called "materiality". This essentially argues that transactions should only be included for accounting purposes when they're significant enough. An $8 sandwich paid for in bitcoins probably doesn't count. A $30,000 Harley probably would, though.

In theory, then, the IRS rules seem to bring advantages to those who invest in bitcoin as a long-term property-class financial asset, while discouraging those that want to use it as a form of digital currency. In practice, Boiles argues that the latter group probably won't care, and won't report it.

Merchants and payment processors

There are two other types of business that might be affected by the new IRS guidance: merchants, and the payment processors that support them.

The payment processors - known as third-party settlement organizations (TPSOs) in tax-speak - are now required to file 1099-K reports for their merchants if the number of transactions settled for the merchant exceeds 200, and the gross amount of payments made to the merchant exceeds $20,000.

Coinbase didn't return our request for comment, but BitPay, the other large processor in the bitcoin space, said that it does file 1099-K forms for merchants.

For many merchants, these tax rules shouldn't change much. Many, such as Overstock, take payments in bitcoin via payment processors but have them immediately converted to fiat currency, meaning that they don't hold a position in the digital currency, and therefore won't be exposed to capital gains taxes. It will be up to the payment processors to simply send them a 1099-K form at the end of the year.

Companies, contractors, and employees

Contractors getting paid in bitcoin must declare its fair market value on the day of payment as part of their gross income. Companies paying salaries in bitcoin must withhold tax in the same way as they would if paying in regular fiat currency. There don't seem to be many of the latter, though.

So, the burning question is - what do you do with those bitcoins that you mined or bought two years ago and let languish on your hard drive? Don't be naughty, advises Broiles: report them.

"I think that IRS is going to want you to amend past-year returns," he says. Let's say that someone mined a lot of bitcoin two years ago and then forgot about it. My suggestion would be to amend the tax return for the year when they mined it. The growth between long ago and today will be taxed at the long-term capital gain rate."

None of this is set in stone. Tax attorneys and other experts will no doubt file commentary on the IRS notice, which is subject to change, and which should eventually be replaced by regulation that could differ in its approach. For now, though, at least the bitcoin community in America has something to go on.

Statements in this article should not be considered tax advice, which is best sought directly from a qualified professional.